U.S.
      SECURITIES AND EXCHANGE COMMISSION


Washington,
      D.C. 20549




FORM
      10-QSB




ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
      EXCHANGE ACT OF 1934





**For
      the quarterly period ended June 30, 2007**


OR


 ̈ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
      EXCHANGE ACT OF 1934


**Commission
      file number 000-49636**




**VIKING
      SYSTEMS, INC.**


(Exact
      Name of Small Business Issuer as specified in its charter)





Delaware
            
            86-0913802(State
                or other jurisdiction of incorporation or organization)
            
            (I.R.S.
                employer identification No.)





4350
      La Jolla Village Drive, Suite 900, San Diego, CA 92122


(Address
      of principal executive offices)





(858)431-4008


Issuer’s
      telephone number





N/A


(Former
      name, former address, and former fiscal year, if changed since last
      report)





Securities
      registered pursuant to Section 12(b) of the Exchange Act: None





Securities
      registered pursuant to Section 12(g) of the Exchange Act: $.001 Par Value Common
      Stock





Check
      whether the Issuer (1) has filed all reports required to be filed by Section
      13
      or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter
      period that the registrant was required to file such reports), and (2) has
      been
      subject to such filing requirements for the past 90 days. (1) Yes ý No  ̈ (2) Yes ý No  ̈





Indicate
      by check mark whether the registrant is an accelerated filer (as defined in
      rule
      12b-2 of the Exchange Act). Yes  ̈ No ý


Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). Yes  ̈ No ý




As
      of
      August 14, 2007, there were 69,456,675 shares of our Common Stock
      outstanding.





Transitional
      Small Business Disclosure Format Yes  ̈ No ý





DOCUMENTS
      INCORPORATED BY REFERENCE: NONE








**FORM
      10-QSB**





**FINANCIAL
      STATEMENTS AND SCHEDULES**


**VIKING
      SYSTEMS, INC.**





**For
      the Quarter ended June 30, 2007**





**PART
      I - FINANCIAL INFORMATION**





Page
                ofForm
                10-QSBItem
                1.
            Financial
                Statements (unaudited):Balance
                Sheets at June 30, 2007 and December 31, 2006
            3Statements
                of Operations for the Three and Six Months Ended June 30, 2007 and
                2006
            4Statements
                of Cash Flows for the Six Months Ended June 30, 2007 and
                2006
            5Notes
                to Financial Statements
            7 -
                19Item
                2.
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            20Item
                3.
            Controls
                and Procedures
            30




**PART
      II - OTHER INFORMATION**




PageItem
                1.
            Legal
                Proceedings
            30Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds.
            30Item
                3.
            Defaults
                Upon Senior Securities
            30Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            30Item
                5.
            Other
                Information
            31Item
                6.
            Exhibits
            32








**PART
      I - FINANCIAL INFORMATION**


**ITEM
      1: FINANCIAL STATEMENTS**


**VIKING
      SYSTEMS, INC.**


**Balance
      Sheets - Unaudited**


**June
                30,**
              **2007**
            
            **December
                31,**
              **2006****Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            314,580
            
            $
            440,465Restricted
                cash
            
            
            200,000
            
            
            --Accounts
                receivable, net
            
            
            2,045,814
            
            
            855,299Inventories
            
            
            1,941,651
            
            
            1,117,929Prepaid
                expenses
            
            
            47,515
            
            
            34,208Other
                current assets
            
            
            293,465
            
            
            72,535Total
                current assets
            
            
            4,843,025
            
            
            2,520,436Property
                and equipment, net
            
            
            612,856
            
            
            594,402Debt
                issuance costs
            
            
            76,247
            
            
            -Intangible
                assets, net
            
            
            315,000
            
            
            350,000Total
                Assets
            
            $
            5,847,128
            
            $
            3,464,838**Liabilities
                and Stockholders' Deficit**Current
                liabilities:Accounts
                payable
            
            $
            1,602,491
            
            $
            1,037,334Accrued
                expenses
            
            
            1,953,392
            
            
            1,780,302Deferred
                revenue
            
            
            103,127
            
            
            100,181Capital
                lease obligations - current
            
            
            37,529
            
            
            36,649Deposit
                on debenture financing
            
            
            200,000
            
            
            -Notes
                payable
            
            
            589,579
            
            
            350,000Derivative
                liabilities
            
            
            9,366,105
            
            
            3,373,676Total
                current liabilities
            
            
            13,852,223
            
            
            6,678,142Capital
                lease obligations
            
            
            56,577
            
            
            77,253Commitments
                and contingenciesSeries
                B preferred stock, $0.001 par value; 8,000 shares authorized and
                issued;
                7,828 and 8,000 shares outstanding at June 30, 2007 and December
                31, 2006
                respectively, (aggregate liquidation preference of $8,537,721 at June
                30, 2007 and $8,391,014 at December 31, 2006).
            
            
            8,537,721
            
            
            8,391,014Stockholders'
                deficit:Preferred
                stock, $.001 par value, 25,000,000 shares authorized, no shares
                outstanding
            
            
            -
            
            
            -Common
                stock, $.001 par value, 400,000,000 shares authorized, 66,855,918
                shares
                issued and outstanding at June 30, 2007; 200,000,000 shares authorized
                and
                61,864,941 shares issued and outstanding at December 31,
                2006.
            
            
            66,856
            
            
            61,865Additional
                paid-in capital
            
            
            7,692,496
            
            
            6,804,876Accumulated
                deficit
            
            
            (24,358,745
            )
            
            (18,548,312
            )Total
                stockholders' deficit
            
            
            (16,599,393
            )
            
            (11,681,571
            )Total
                liabilities and stockholders' deficit
            
            $
            5,847,128
            
            $
            3,464,838


See
      accompanying notes to financial statements


3


**VIKING
      SYSTEMS, INC.**


**Statements
      of Operations - Unaudited**




**Three
                Months Ended**
            
            **Six
                Months Ended****June
                30,**
            
            **June
                30,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Sales,
                net
            
            $
            2,849,544
            
            $
            883,180
            
            $
            4,774,789
            
            $
            2,138,024Cost
                of sales
            
            
            2,034,756
            
            
            742,823
            
            
            3,414,971
            
            
            1,632,700Gross
                profit
            
            
            814,788
            
            
            140,357
            
            
            1,359,818
            
            
            505,324Operating
                expenses:General
                and administrative
            
            
            748,488
            
            
            684,434
            
            
            1,380,562
            
            
            1,213,624Selling
                and marketing
            
            
            1,424,027
            
            
            1,135,241
            
            
            2,568,800
            
            
            2,009,609Research
                and development
            
            
            626,512
            
            
            314,036
            
            
            1,038,429
            
            
            624,260Total
                operating expenses
            
            
            2,799,027
            
            
            2,133,711
            
            
            4,987,791
            
            
            3,847,493Operating
                loss
            
            
            (1,984,239
            )
            
            (1,993,354
            )
            
            (3,627,973
            )
            
            (3,342,169
            )Other
                income (expense):Interest
                income
            
            
            14,045
            
            
            21,787
            
            
            29,454
            
            
            21,787Interest
                expense
            
            
            (230,628
            )
            
            (160,584
            )
            
            (412,915
            )
            
            (305,995
            )Gain
                on extinguishment of debt
            
            
            -
            
            
            4,975,824
            
            
            -
            
            
            4,975,824Amortization
                of debt discount
            
            
            (462,056
            )
            
            (5,500,000
            )
            
            (605,486
            )
            
            (8,480,878
            )Accrued
                liquidated damages
            
            
            (577,616
            )
            
            -
            
            
            (577,616
            )
            
            -Gain
                (loss) on derivative liability
            
            
            1,816,842
            
            
            (1,612,610
            )
            
            (615,897
            )
            
            (1,612,610
            )Net
                loss
            
            
            (1,423,652
            )
            
            (4,268,937
            )
            
            (5,810,433
            )
            $
            (8,744,041
            )Series
                B Preferred stock Dividend
            
            
            (163,408
            )
            
            (8,068,384
            )
            
            (324,723
            )
            
            (8,068,384
            )Net
                loss applicable to common stockholders
            
            $
            (1,587,060
            )
            $
            (12,337,321
            )
            $
            (6,135,156
            )
            $
            (16,812,425
            )Net
                loss applicable to common stockholders per share - basic and
                diluted
            
            $
            (0.02
            )
            $
            (0.27
            )
            $
            (0.09
            )
            $
            (0.41
            )Weighted
                average shares - basic and diluted
            
            
            66,446,727
            
            
            45,173,339
            
            
            64,941,972
            
            
            40,605,421




See
      accompanying notes to financial statement **s**





4


**VIKING
      SYSTEMS, INC.**


**Statements
      of Cash Flows - Unaudited**





**Six
                Months ended June 30,**
              **2007**
            
            **Six
                Months ended June 30,**
              **2006****Cash
                flows from operating activities:**Net
                loss
            
            $
            (5,810,433
            )
            $
            (8,744,041
            )Adjustment
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            254,322
            
            
            165,572Common
                stock issued for services
            
            
            -
            
            
            44,041Stock
                based compensation expense
            
            
            199,318
            
            
            242,364Amortization
                of debt discount
            
            
            605,486
            
            
            8,480,878Gain
                on extinguishment of debt
            
            
            -
            
            
            (4,975,824
            )Loss
                on derivative liability
            
            
            615,897
            
            
            1,612,610Change
                in operating assets and liabilities:Accounts
                receivable, net
            
            
            (1,190,515
            )
            
            (28,610
            )Inventories,
                net
            
            
            (978,407
            )
            
            (324,177
            )Prepaid
                expenses
            
            
            (13,307
            )
            
            15,802Other
                current assets
            
            
            (220,930
            )
            
            (44,504
            )Accounts
                payable
            
            
            565,157
            
            
            177,300Accrued
                salaries and related expenses
            
            
            157,910
            
            
            12,209Accrued
                royalties
            
            
            -
            
            
            14,044Other
                accrued expenses
            
            
            861,714
            
            
            84,765Deferred
                revenue
            
            
            2,946
            
            
            15,188Net
                cash used in operating activities
            
            
            (4,950,842
            )
            
            (3,252,383
            )**Cash
                flows from investing activities:**Purchase
                of property and equipment
            
            
            (83,095
            )
            
            (112,421
            )Net
                cash used in investing activities
            
            
            (83,095
            )
            
            (112,421
            )


**Cash
                flows from financing activities:**Net
                change in short-term bank borrowings
            
            
            -
            
            
            (211,200
            )Proceeds
                from issuance of preferred stock, net
            
            
            -
            
            
            7,250,000Payment
                of preferred stock offering costs
            
            
            (47,152
            )
            
            (436,142
            )Proceeds
                from related party notes
            
            
            300,000
            
            
            200,000Repayment
                of capital lease obligations
            
            
            (19,796
            )
            
            (200,000
            )Proceeds
                from convertible debt
            
            
            4,675,000
            
            
            250,000Net
                cash provided by financing activities
            
            
            4,908,052
            
            
            6,852,658Net
                (decrease) increase in cash and cash equivalents
            
            
            (125,885
            )
            
            3,487,854Cash
                and cash equivalents at beginning of period
            
            
            440,465
            
            
            434,503Cash
                and cash equivalents at end of period
            
            $
            314,580
            
            $
            3,922,357**Supplemental
                disclosure of cash flow information:**Cash
                paid during the period for:Interest
            
            $
            167,263
            
            $
            150,428Income
                taxes
            
            $
            -
            
            $
            -




See
      accompanying notes to financial statements


5





**Non-Cash
      Investing and Financing Activity**


*Six
      months ended June 30, 2007:*





During
      the six months ended June 30, 2007, the Company:





**·**
            Converted
                $350,000 in notes payable and $6,534 in accrued interest into $356,534
                in
                convertible notes payable in February 2007.**·**
            Converted
                $300,000 of related party notes payable held by Donald Tucker, a
                significant shareholder and the Company’s President and Chief Executive
                Officer, into $300,000 into convertible debentures in February 2007.**·**
            Issued
                4,000,000 shares of common stock with a fair value of $840,000 for
                liquidated damages to Series B Preferred stockholders pursuant to
                the
                February 2007 convertible debt transaction.**·**
            Issued
                990,977 shares of common stock in connection with the conversion
                of 172
                shares of Series B Preferred stock plus certain accrued
                dividends.**·**
            Recorded
              derivative liability of $5,376,533 in connection with convertible
              debenture financing in February
              2007.





During
      the *six
      months ended June 30, 2006, the Company:*





****·****
            Converted
                $4,300,000 of convertible notes payable into 23,888,891 shares of
                common
                stock.**·**
            Converted
                $450,000 of convertible notes payable held by Donald Tucker, a significant
                shareholder and the Company’s President and Chief Executive Officer, into
                2,500,000 shares of common stock .**·**
            Converted
                $750,000 of convertible notes payable into 750 shares of Series B
                Preferred stock.**·**
            Issued
                837,000 shares of common stock pursuant to a cashless exercise of
                1,000,000 non-qualified stock options issued in December
                2003.








See
      accompanying notes to financial statements


6





**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**





**1.
      INTERIM FINANCIAL STATEMENTS**





The
      balance sheet of Viking Systems, Inc. (“Viking” or the “Company”) as of June 30,
      2007 and the statements of operations and cash flows for the periods ended
      June
      30, 2007 and 2006 are unaudited. However, management, in its opinion, has made
      all adjustments (consisting only of normal recurring accruals) necessary to
      present fairly the financial position, results of operations and cash flows
      for
      the periods presented. The balance sheet as of December 31, 2006 was derived
      from the company’s audited financial statements. The financial statements and
      notes thereto should be read in conjunction with the financial statements and
      notes for the years ended December 31, 2006, included in Viking Systems,
      Inc.’s Form 10-KSB filed on April 17, 2007 with the Securities and Exchange
      Commission. The results of operations and cash flows for the three and six
      months ended June 30, 2007 are not necessarily indicative of results to be
      expected for the fiscal year ending December 31, 2007.





**2.
      LIQUIDITY AND GOING CONCERN**





The
      accompanying financial statements have been prepared on a going concern basis
      which contemplates the realization of assets and the satisfaction of liabilities
      in the normal course of business. Historically, the Company has incurred
      significant losses and has not demonstrated the ability to generate sufficient
      cash flows from operations to satisfy its liabilities and sustain operations.
      Our independent registered public accounting firm included a going concern
      uncertainty explanatory paragraph in their report dated March 20, 2007, which
      is
      included in our Form 10-KSB for the year ended December 31, 2006.





The
      Company’s continuation as a going concern is dependent on its ability to
      generate sufficient income and cash flow to meet its obligations on a timely
      basis and/or obtain additional financing as may be required. During the six
      months ended June 30, 2007, the Company generated net proceeds of approximately
      $4.9 million from financing activities. In addition, the Company continues
      to
      examine all aspects of its business for areas of improvement and continues
      to
      focus on increasing revenues and gross margins, reducing its fixed cost base
      and
      improving the Company’s working capital position. However, if anticipated
      improvements in operating results and cash flows from operations do not
      materialize, the Company will need to further reduce expenses. The Company
      also
      will require additional equity or debt financing to meet its working capital
      requirements. The sale of additional equity securities or debt financing could
      result in additional dilution to the Company’s current stockholders. There can
      be no assurance that additional financing, if required, will be available on
      terms satisfactory to the Company.





The
      financial statements included herein do not include any adjustments relating
      to
      the recoverability and classification of recorded assets or the amount or
      classification of liabilities or any other adjustments that might be necessary
      should the Company be unable to continue as a going concern.





**3.
      EARNINGS (LOSS) PER SHARE**





Due
      to the net losses for the three and six month periods ended June 30, 2007 and
      2006, potentially dilutive securities have been excluded in the calculation
      of
      diluted loss per share because their inclusion would be anti-dilutive.
      Accordingly, the weighted average shares used in the calculation of basic and
      diluted loss per share for the three and six month period ended June 30, 2007
      presented are the same. For the purposes of this calculation, net loss for
      the
      three and six months ended June 30, 2007 has been adjusted for dividends on
      preferred stock accrued during the period.


7





**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**





**4.
      INVENTORY**




Details
      of our inventory account balances are as follows:





**June
                30,**
              **2007**
            
            **December
                31,**
              **2006**Inventories:Parts
                and supplies
            
            $
            1,170,281
            
            $
            558,699Work-in-progress
            
            
            550,832
            
            
            344,483Finished
                goods
            
            
            302,075
            
            
            310,559Valuation
                reserve
            
            
            (81,537
            )
            
            (95,782
            )$
            1,941,651
            
            $
            1,117,929





**5.
      ACCRUED EXPENSES**





Accrued
      expenses consist of the following:





**June
                30,**
              **2007**
            
            **December
                31,**
              **2006**Accrued
                wages and salaries
            
            $
            510,300
            
            $
            352,390Accrued
                liquidated damages
            
            
            580,333
            
            
            840,000Accrued
                registration delay fees
            
            
            258,300
            
            
            192,300Accrued
                board of director fees
            
            
            185,625
            
            
            151,625Accrued
                debenture interest
            
            
            107,532
            
            
            -Other
                accrued expenses
            
            
            311,302
            
            
            243,987$
            1,953,392
            
            $
            1,780,302








**6.
      RESTRICTED CASH AND DEPOSIT ON DEBENTURE FINANCING**





The
      $200,000 amount classified as "Restricted cash" and "Deposit on debenture
      financing," on the June 30, 2007 balance sheet represents cash received in
      June
      2007 from Brian Miller, a shareholder and Director. This cash was for the
      purchase of the Company's convertible debentures. This financing transaction
      was
      completed and closed in July 2007 and at that time the Convertible Debentures
      were issued. See Note 16.





**7.
      INCOME TAXES**





Viking
      Systems accounts for income taxes using the asset and liability method. Under
      the asset and liability method, deferred tax assets and liabilities are
      recognized for the future tax consequences attributable to differences between
      the financial statement carrying amounts of existing assets and liabilities
      and
      their respective tax bases. Deferred tax assets and liabilities are measured
      using enacted tax rates expected to apply to taxable income in the years in
      which those temporary differences are expected to be recovered or settled.
      The
      effect on deferred tax assets and liabilities of a change in tax rates is
      recognized in income in the period that includes the enactment date. A valuation
      allowance is recognized against deferred tax assets when it is more likely
      than
      not that the assets will not be realized.





Effective
      January 1, 2007, the Company adopted the provisions of Financial Accounting
      Standards Board ("FASB") Interpretation No. 48 ("FIN 48"), "Accounting for
      Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109."
      The
      implementation of FIN 48 had no impact on the Company's financial statements.




The
      Company is primarily subject to U.S. federal and state income tax. Tax years
      ended December 31, 2004 and after remain open to examination by U.S. federal
      and
      state tax authorities. The Company's policy is to recognize interest and
      penalties related to income tax matters in income tax expense. As of January
      1
      and June 30, 2007, the Company had no accruals for interest or penalties related
      to income tax matters.








8











**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**





**8.
      STOCK-BASED COMPENSATION**




On
      January 1, 2006, the Company adopted Statement of Financial Accounting Standards
      (“SFAS”) No.123 (Revised 2004), “Share Based Payment,” (“SFAS 123R”), using the
      modified prospective method. In accordance with SFAS 123R, the Company measures
      the cost of employee services received in exchange for an award of equity
      instruments based on the grant-date fair value of the award. That cost is
      recognized over the period during which an employee is required to provide
      service in exchange for the award - the requisite service period. The Company
      determines the grant-date fair value of employee share options using the
      Black-Scholes option-pricing model.




Under
      the
      modified prospective approach, SFAS 123R applies to new awards and to awards
      that were outstanding on January 1, 2006 that are subsequently modified,
      repurchased or cancelled. Under the modified prospective approach, compensation
      cost includes compensation cost for all share-based payments granted prior
      to,
      but not yet vested on, January 1, 2006, based on the grant-date fair value
      estimated in accordance with the pro forma provisions of SFAS 123, and
      compensation cost for all share-based payments granted subsequent to January
      1,
      2006, based on the grant-date fair value estimated in accordance with the
      provisions of SFAS 123R. Prior periods were not restated to reflect the impact
      of adopting the new standard. During the three months ended June 30, 2007 and
      2006, the Company recorded $124,586 and $85,752, respectively, and during the
      six months ended June 30, 2007 and 2006 the Company recorded $199,318 and
      $242,364, respectively, in non-cash stock-based compensation expense pursuant
      to SFAS 123R. As of June 30, 2007, there was approximately $465,600 of
      total unrecognized compensation costs related to unvested options, which is
      expected to be recognized over a weighted average period of approximately 2.1
      years.





The
      fair value of stock options at date of grant was estimated using the
      Black-Scholes model with the following assumptions: expected volatility ranging
      from 76.89% to 112.28%, expected term of 7.5 years, risk-free interest rate
      ranging from 4.30% to 5.23%, and expected dividend yield of 0%. Expected
      volatility is based on the historical volatilities of the Company’s common
      stock. The expected life of employee stock options is determined using
      historical data of employee exercises and represents the period of time that
      stock options are expected to be outstanding. The risk free interest rate is
      based on U.S. Treasury constant maturing for the expected life of the stock
      option.





The
      following table summarizes the stock option transactions during the six months
      ended June 30, 2007:




**Number
                of**
              **Shares**
            
            **Weighted
                - Average**
              **Exercise
                Price**
            
            **Weighted
                - Average**
              **Contractual
                Life**
              **(in
                years)**Options
                outstanding December 31, 2006
            
            
            6,976,000
            
            $
            0.42
            
            
            4.95Granted
            
            
            1,040,000
            
            
            0.20
            
            
            9.73Exercised
            
            
            -
            
            
            -
            
            
            -Cancelled
            
            
            (450,000
            )
            
            0.41
            
            
            -Options
                outstanding June 30, 2007
            
            
            7,566,000
            
            $
            0.39
            
            
            6.37Options
                exercisable at June 30, 2007
            
            
            4,718,000
            
            $
            0.43
            
            
            3.75














9







**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**





**9.
      RECENT ACCOUNTING PRONOUNCEMENTS**





In
      June
      2006, the Financial Accounting Standards Board ("FASB") ratified the consensus
      on Emerging Issues Task Force ("EITF") Issue No. 06-3, “How Taxes Collected from
      Customers and Remitted to Governmental Authorities Should Be Presented in the
      Income Statement" ("EITF No. 06-3"). The scope of EITF No. 06-3 includes any
      tax
      assessed by a governmental authority that is directly imposed on a
      revenue-producing transaction between a seller and a customer and may include,
      but is not limited to, sales, use, value added, Universal Service Fund ("USF")
      contributions and some excise taxes. The Task Force affirmed its conclusion
      that
      entities should present these taxes in the income statement on either a gross
      or
      a net basis, based on their accounting policy, which should be disclosed
      pursuant to APB Opinion No. 22, "Disclosure of Accounting Policies." If such
      taxes are significant and are presented on a gross basis, the amounts of those
      taxes should be disclosed. The consensus on EITF No. 06-3 is effective for
      interim and annual reporting periods beginning after December 15, 2006. The
      adoption of EITF Issue No. 06-3 during the first quarter of 2007 did not have
      a
      significant impact on our financial position, results of operations or cash
      flows.





In
      November 2006, the EITF reached a final consensus in EITF Issue 06-06 “Debtor’s
      Accounting for a Modification (or Exchange) of Convertible Debt Instruments”
(“EITF No. 06-6”). EITF No. 06-6 addresses the modification of a convertible
      debt instrument that changes the fair value of an embedded conversion option
      and
      the subsequent recognition of interest expense for the associated debt
      instrument when the modification does not result in a debt extinguishment
      pursuant to EITF No. 96-19, “Debtor’s Accounting or a Modification or Exchange
      of Debt Instruments.” The consensus should be applied to modifications or
      exchanges of debt instruments occurring in interim or annual periods beginning
      after November 29, 2006. The adoption of EITF 06-6 during the first quarter
      of
      2007 did not have a material impact on our consolidated financial position,
      results of operations or cash flows.





In
      November 2006, the FASB ratified EITF Issue No. 06-7, “Issuer’s Accounting for a
      Previously Bifurcated Conversion Option in a Convertible Debt Instrument When
      the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement
      No. 133, Accounting for Derivative Instruments and Hedging Activities” (“EITF
      No. 06-7”). At the time of issuance, an embedded conversion option in a
      convertible debt instrument may be required to be bifurcated from the debt
      instrument and accounted for separately by the issuer as a derivative under
      SFAS
      No. 133, based on the application of EITF No. 00-19. Subsequent to the issuance
      of the convertible debt, facts may change and cause the embedded conversion
      option to no longer meet the conditions for separate accounting as a derivative
      instrument, such as when the bifurcated instrument meets the conditions of
      EITF
      No. 00-19 to be classified in stockholders’ equity. Under EITF No. 06-7, when an
      embedded conversion option previously accounted for as a derivative under
      Statement of Financial Accounting Standards (“SFAS”) No. 133 no longer meets the
      bifurcation criteria under that standard, an issuer shall disclose a description
      of the principal changes causing the embedded conversion option to no longer
      require bifurcation under SFAS No. 133 and the amount of the liability for
      the
      conversion option reclassified to stockholders’ equity. EITF No. 06-7 should be
      applied to all previously bifurcated conversion options in convertible debt
      instruments that no longer meet the bifurcation criteria in SFAS No. 133 in
      interim or annual periods beginning after December 15, 2006, regardless of
      whether the debt instrument was entered into prior or subsequent to the
      effective date of EITF No. 06-7. The adoption of EITF 06-7 during the first
      quarter of 2007 did not have a material impact on our financial position,
      results of operations or cash flows.





**10.
      CONVERTIBLE NOTES PAYABLE**





During
      January 2007, we issued a $300,000 promissory note to our CEO who is also a
      significant shareholder and Director. The promissory note and the $350,000
      Note
      payable issued by the Company in December 2006 were converted into the February
      2007 debentures described below.




In
      February 2007, Viking Systems **** issued
      a
      total of $5,376,533 of convertible debentures (“Debentures”) to 13 investors
      (the "Investors"). Net proceeds from the issuance of the Debentures consisted
      of
      $4,675,000 in cash, net of $45,000 of offering costs retained by certain of
      the
      investors, and conversion of $656,533 of notes payable and accrued interest.
      On
      July 31, 2007, an additional $2,600,000 of the Debentures were sold on the
      same
      terms and conditions as the Debentures sold in February 2007. The general terms
      of this financing are as follows:





Maturity
      Date of Notes


The
      Debentures are due February 28, 2009, subject to acceleration rights which
      holders have in the event of default.





Interest
      Rate


Eight
      percent per annum, payable quarterly and, subject to certain conditions, Viking
      may pay interest by issuing the holders of the Debentures shares of Viking
      common stock.




10


**VIKING
      SYSTEMS, Inc.**


**Notes
      to Financial Statements (Unaudited)**







Security


The
      Debentures are secured by all of the assets of Viking.





Optional
      Conversion by Investors


The
      Debentures may, at the option of each holder of Debentures, be converted into
      shares of Viking common stock at the price of $0.18 per share. In the event
      Viking does not achieve certain operational milestones, as defined, during
      the
      first three quarters of 2007, the conversion price will be reduced to $0.12
      per
      share. The conversion price is also subject to downward adjustment in the event
      of subsequent equity sales, rights offerings and pro-rata distributions by
      Viking, at the time of the filing of the registration statement for the shares
      underlying the Debentures, and upon certain other conditions pursuant to the
      terms of Security Purchase Agreement, the Debentures and other Transaction
      Documents. If all Debenture holders were to convert all of the Debentures
      outstanding at June 30, 2007 into common stock at the initial conversion price,
      approximately 29.9 million shares of common stock will be issued in such
      conversion.





Optional
      Redemption by Viking


The
      Company may not prepay the Debentures but it may redeem some or all of them
      if
      certain conditions are met. The Optional Redemption Amount equals 120% of the
      principal amount of the Debentures redeemed if the redemption occurs prior
      to
      the first anniversary date of the issuance of the Debentures and 140% of the
      principal amount of the Debentures redeemed if the redemption occurs after
      the
      first anniversary date of the issuance of the Debentures but prior to the second
      anniversary date of issuance. The conditions for optional redemption have not
      been met.




Warrants


As
      additional consideration, Viking issued the Investors Warrants to purchase
      shares of Viking common stock at the price of $0.18 per share. In the event
      Viking does not achieve certain operational milestones, as described, during
      the
      first three quarters of 2007, the exercise price will be reduced to $0.12 per
      share. The exercise price is also subject to downward adjustment, upon certain
      conditions, similar to the conditions requiring adjustment to the
      debentures, pursuant to the terms of Security Purchase Agreement, the
      Warrant and other Transaction Documents. The Warrants are exercisable for a
      period of seven years from the date of issuance. The Warrants provide that
      each
      Investor is able to purchase that number of shares of common stock of Viking
      that equals 50% of the number of shares issuable upon conversion of the
      Debentures.





Registration
      Rights


Viking
      has agreed to register with the Securities and Exchange Commission the shares
      of
      common stock that are issuable upon the conversion of the Debentures and the
      shares of common stock that underlie the Warrants (the “Debenture Transaction
      Shares”). Viking will pay all expenses and cost of registration except for
      commissions. In the event that Viking fails to file or if the securities
      underlying the debentures and warrants are not registered by the dates agreed
      to
      in the transaction documents, Viking will be required to pay liquidated damages
      to the Holders. Such liquidated damages amount to 2% per month but will not
      exceed 18% of the face amount of the Debentures. Viking was required to file
      an
      initial registration statement by April 2, 2007 and has not yet completed this
      filing. Viking has not filed a registration statement relating to the Debenture
      Transaction Shares, which constitutes a default by Viking of the terms and
      conditions of the Debenture transaction documents.





On
      July
      19, 2007, Viking and the Debenture holders entered into a Consent, Waiver and
      Amendment Agreement dated June 22, 2007, pursuant to which Viking agreed to
      issue to the Investors a total of 2,389,570 shares of Viking common stock in
      lieu of the payment of (i) accrued but unpaid cash liquidated damages and (ii)
      the payment of accrued interest on the Debentures through June 30, 2007. These
      shares were issued by Viking in July 2007.  At June 30, 2007, the Company
      had accrued $107,531 related to the debenture interest and $322,592 related
      to
      the debenture liquidated damages.




11


**VIKING
        SYSTEMS, Inc.**
 **Notes
        to Financial Statements (Unaudited)**


Additional


Pursuant
      to the Securities Purchase Agreement, the Holders were granted certain rights
      to
      participate in subsequent financings by Viking.




In
      February 2007, we received the consent of our Series B Preferred Shareholders
      to
      consummate the convertible debenture financing and executed a consent and waiver
      agreement as described below.





The
      Debentures were assessed under SFAS No. 133 and management determined that
      the
      conversion option represented an embedded derivative liability. Accordingly,
      the
      Company bifurcated the embedded conversion option and accounted for it as a
      derivative liability. In accordance with SFAS No. 133, the embedded conversion
      option of the Debenture was revalued each period end and the change in fair
      value was reflected as a gain (loss) for the period. The proceeds received
      on
      issuance of the February 2007 Debentures were first allocated to the fair value
      of the bifurcated conversion option and the fair value of the derivative
      liability resulting from the warrants issued in connection with the Debentures.
      The aggregate fair values of the embedded conversion option and the warrant
      derivative liability totaled $6,859,608. Of this total, $5,376,533 was recorded
      as a discount to the face amount the February 2007 Debentures, and $1,483,075
      was recorded as a loss on derivative liability. The recorded discount is being
      accreted as interest expense using the effective interest method over the term
      of the Debentures.




The
      carrying value of the debentures will accrete up to the face value over the
      life
      of the Debentures. The Company recorded accretion of $589,578 during the six
      months ended June 30, 2007 related to the February 2007 Debentures. The amount
      recorded on the balance sheet at June 30, 2007 has been calculated as
      follows:





Face
                value of the Debentures at inception
            
            $
            5,376,533Discount
                recorded in connection with derivative liabilities
            
            
            (5,376,533
            )Accretion
                of discount
            
            
            589,579Carrying
                value at June 30, 2007
            
            $
            589,579








**11.
      SERIES B CONVERTIBLE PREFERRED STOCK**





In
      May 2006, our Board of Directors adopted a resolution designating a Series
      B
      preferred stock consisting of 8,000 shares. All 8,000 shares of Series B
      Preferred Stock (“Preferred Stock”) authorized have been issued. Each share of
      Series B Preferred, par value $0.001 per share, with a stated value of
      $1,000 per share (“Stated Value”), is convertible, subject to adjustments,
      into approximately 5,555 shares of common stock and warrants to purchase an
      additional 2,778 shares of common stock at an initial price of $0.35 per share
      (reduced to $0.18 in February 2007). In May 2006, the Company issued the
      Series B Preferred stock for gross proceeds of $8,000,000, and incurred
      approximately $436,143 in issuance costs, which are recorded as a discount
      to
      the carrying value of the Series B Preferred stock. Proceeds from the sale
      of Series B Preferred stock consisted of $7,250,000 in cash and the conversion
      of $750,000 of convertible notes.





The
      Company applied the proceeds for general corporate purposes. The Company has
      recorded the redeemable convertible preferred stock as mezzanine equity on
      the
      accompanying balance sheet in accordance with the provisions of Emerging Issues
      Task Force (“EITF”) Topic D-98: “Classification and Measurement of Redeemable
      Securities” (“EITF Topic D-98”).





During
      the six months ended June 30, 2007, the Company recorded preferred stock
      dividends of approximately $324,723 as an increase to the net loss available
      to
      common stockholders in the accompanying consolidated statement of operations.
      Dividends accrued and amounting to approximately $710,000 remain unpaid as
      of
      June 30, 2007.





The
      following table summarizes the change in carrying value of the Series B
      Preferred stock for the six months ended June 30, 2007.




Carrying
                value of convertible preferred stock at December 31, 2006
            
            $
            8,391,014Plus:Accrued
                dividends
            
            
            324,723Less:Conversion
                of shares to common stock
            
            
            (172,000
            )Dividend
                on converted preferred shares to common stock
            
            
            (6,016
            )Carrying
                value of convertible preferred stock at June 30, 2007
            
            $
            8,537,721




12


**VIKING
        SYSTEMS, Inc.**
 **Notes
        to Financial Statements (Unaudited)**


Conversion .
      The
      stated value of the shares of Preferred Stock are initially convertible into
      shares of Viking’s common stock at a price of $0.18 per share; however, the
      conversion price is subject to adjustment based upon certain conditions. 
At June 30, 2007, if all shares of Preferred Stock are converted into common
      stock at the initial conversion price, of which there can be no assurance,
      approximately 43,488,889 shares of common stock will be issued in such
      conversion.





The
      Company is in default with respect to its obligation to pay dividends on the
      Preferred Stock. We have accumulated unpaid preferred stock dividends at June
      30, 2007 in the amount of $710,000. The Company has not had sufficient capital
      to pay such dividends in cash. Although the Company does not have a contractual
      right to pay the dividends in common stock, we intend to discuss with our
      preferred shareholders paying the accrued dividends and future dividends in
      stock. There can be no assurance that the preferred stockholders will allow
      dividends to be paid with shares rather than cash and if this were to occur,
      Viking may not have the cash necessary to pay such dividends. We continue to
      accrue approximately $161,000 in preferred dividends on a quarterly
      basis.





Pursuant
      to the terms and conditions of the preferred stock transaction, Viking agreed
      to
      register the shares of common stock underlying the Preferred Stock and Warrants
      (the “Preferred Stock Transaction Shares”). Some of the Preferred Stock
      Transaction Shares were registered, however, other Preferred Stock Transaction
      Shares were not registered as a result of the Securities and Exchange
      Commission’s interpretation of Rule 415. The failure to register all of the
      Preferred Stock Transaction Shares resulted in a default by Viking of the terms
      and conditions of the Preferred Stock Transaction documents. Viking and the
      Preferred Stockholders have entered into a Consent, Waiver and Amendment
      Agreement pursuant to which:





**·**
            In
                exchange for the waiver by the Preferred Stockholders of the default
                with
                respect to the failure to register all of the preferred Stock Transaction
                Shares, Viking agreed to issue the Preferred Stockholders a total
                of
                4,000,000 shares of Viking common stock;
                and





**·**
            In
                order to facilitate the issuance of the Debentures, the Preferred
                Stockholders consented to the issuance of the Debentures and agreed
                to
                waive certain breaches of the Preferred Stock Financing Documents,
                and Viking agreed to amend certain provisions of the Preferred Stock
                Transaction documents to modify the terms of the 22,222,222 common
                stock
                warrants issued in connection with the Preferred Stock Transaction
                to
                reduce the exercise price from $0.35 to $0.18 and increase the contractual
                life from five years to seven
                years.





Liquidated
      damages in the amount $840,000 were accrued as of December 31, 2006 based on
      the
      estimated fair value of the four million shares of common stock issued by the
      Company in February 2007 pursuant to this agreement.




**12.
      DERIVATIVE LIABILITIES**


Evaluation
        of criteria under Emerging Issues Task Force (“EITF”) Issue 00-19, “Accounting
        for Derivative Instruments Indexed to and Potentially Settled in, a Company’s
        own Stock,” resulted in the determination that the fair value of warrants to
        purchase common stock issued in connection with the Preferred Stock, and
        all
        other issued and outstanding warrants, should be classified as derivative
        liabilities. In accordance with EITF 00-19, warrants classified as
        derivative liabilities are marked to market value each reporting period with
        the
        corresponding non-cash gain or loss reflected in the current period.




The
      following table summarizes warrants to purchase common stock outstanding as
      of
      June 30, 2007:





**Shares**
            
            **Range
                of Exercise Prices**
            
            **Weighted
                Average Exercise Prices**
            
            **Weighted
                Average Remaining Contractual Life (in years)**Warrants
                outstanding December 31, 2006
            
            
            31,694,444
            
            $
            0.35
                - 0.75
            
            $
            0.25
            
            
            4.81Granted
            
            
            14,934,807
            
            
            0.18
            
            
            0.18
            
            
            6.66Exercised
            
            
            -
            
            
            -
            
            
            -
            
            
            -Cancelled
            
            
            -
            
            
            -
            
            
            -
            
            
            -Warrants
                outstanding June 30, 2007
            
            
            46,629,251
            
            $
            0.18
                - 0.75
            
            $
            0.23
            
            
            5.40








13


**VIKING
        SYSTEMS, Inc.**
 **Notes
        to Financial Statements (Unaudited)**


A
      total
      of 14,934,807 warrants granted to purchase common shares during the six months
      ended June 30, 2007 to the purchaser of the Debentures.





In
      February 2007, 22,222,222 warrants granted to purchasers of the Series B
      Convertible Preferred Stock at an initial exercise price of $0.35 were modified
      in connection with the issuance of the Debentures in February 2007. The exercise
      price was reduced to $0.18 and the life increased from five years to seven
      years.





As
      discussed in Note 10, the Company recorded the embedded conversion option of
      the
      Debentures as a derivative liability. Approximately 29,869,000 shares of Common
      Stock will be issued if all Debentures are converted. The aggregate fair value
      of the warrant derivative liability for all warrants and the conversion option
      derivative liability on June 30, 2007 was $9,366,105. During the six months
      ended June 30, 2007, the Company recorded a total non-cash charge of $615,897
      to
      reflect the modification of terms of existing warrants and the resulting change
      in warrant value since December 31, 2006.




During
      the three months ended June 30, 2007, the Company recorded a gain of $1,816,842
      related to the change in valuation of the warrants and conversion option
      derivative liabilities.








**13.
      COMMON STOCK**




In
      January 2007, the majority of shareholders, through written consent, agreed
      to
      amend the Company's Certificate of Incorporation to increase the number of
      authorized number of common shares from 200,000,000 to 400,000,000. In May
      2007,
      we filed the amended Certificate of Incorporation with the State of
      Delaware.







**14.
      REGISTRATION DELAY FEES**





During
      2005, Viking issued Convertible Promissory Notes (“Notes”) to certain accredited
      investors. Each of these investors was also issued a warrant to purchase shares
      of Viking common stock. In May 2006, each of the Note holders converted their
      Notes into shares of Viking common stock. In April 2006, Viking agreed to file,
      prior to June 21, 2006, a registration statement covering the shares of common
      stock issued upon the conversion of $4,750,000 of the Notes and shares of common
      stock underlying the warrants of these former Note holders. As a result of
      the
      required terms of the recently completed Series B Preferred Stock transaction,
      we were unable to include the securities of the former Note holders in the
      first
      registration statement. We anticipate a registration statement covering
      the Securities of these investors will be filed during 2007.





We
      have
      agreed to pay all Note purchasers, who elect to receive it, a registration
      delay
      fee of one percent per month of their initial Note principal balance. The delay
      fee began on June 21, 2006 and terminates on the date the Securities and
      Exchange Commission declares effective a registration statement covering the
      securities of the Note purchasers. Based on this agreement, we are accruing
      approximately $21,000 per month and as of June 30, 2007, we have accrued a
      total
      of $258,300 for such fees.





**15** **.
      RELATED PARTY TRANSACTIONS**




During
      the six months ended June 30, 2007, Viking Systems:





**·**
            During
                January 2007, issued a $300,000 promissory note to Donald E. Tucker,
                our
                President and CEO who is also a significant shareholder and Director.
                The
                promissory note was subsequently converted into Debentures in February
                2007.**·**
            During
                June 2007, we received $200,000 from Brian Miller, a shareholder
                and
                Director, as a deposit which was subsequently converted into Debentures
                in
                July 2007.








14


**VIKING
        SYSTEMS, Inc.**
 **Notes
        to Financial Statements (Unaudited)**


During
      the six months ended June 30, 2006, Viking Systems





**·**
            Converted
                a $450,000 related party note payable to Donald E. Tucker, a significant
                shareholder and the Company’s President and CEO, into 2,500,000 shares of
                common stock.**·**
            Had
                an unsecured note payable to Donald E. Tucker, a significant shareholder
                and the Company’s President and CEO, in the amount of $200,000. This note
                was repaid on June 14, 2006.**·**
            Issued
                87,500 warrants to purchase common stock at an exercise price of
                $0.35 per
                share to Donald E. Tucker, a significant shareholder and the Company's
                President and CEO.**·**
            Cancelled
                1,187,500 warrants to purchase common stock at an exercise price
                of $0.40
                per share that were previously issued to Donald E. Tucker, a significant
                shareholder and the Company's President and
                CEO.





**16.
      SUBSEQUENT EVENTS**




On
      July
      31, 2007, the Company issued $2.6 million of Debentures. These Debentures were
      issued with the same terms and conditions, including without limitation maturity
      date, interest rate, security, conversion price and warrant coverage, as the
      Debentures issued in February 2007. As a result, the total outstanding
      Debentures increased from $5.4 million to $8.0 million.





The
      Company is in default of certain registration rights obligations to its Series
      B
      Preferred shareholders. A registration statement for some, but not all, of
      the
      shares of common stock underlying the Series B Preferred Stock was declared
      effective by the Securities and Exchange Commission (“SEC”) on August 10, 2006.
      As of May 11, 2007, such registration statement was no longer current. As a
      result, on or about July 11, 2007 a “Triggering Event” occurred under the Series
      B Transaction Documents (which provides the Series B Preferred Shareholders
      rights to additional dividends and/or redemption in exchange for common stock).
      As a result of the lapse in the registration statement, the Company’s preferred
      shareholders are entitled to and the Company is currently incurring liquidated
      damages in connection with the previously-registered shares. The Company has
      accrued $257,741 at June 30, 2007 for such liquidated damages. The Company
      has
      prepared and filed an updated registration statement with current financial
      statements by way of a post-effective amendment but such post-effective
      amendment was not yet declared effective at the time of this Quarterly Report
      on
      Form 10-QSB.


15





**ITEM
      2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF
      OPERATIONS**





In
      this
      report references to "Viking," "we," "us," "our" and the “Company” refer to
      Viking Systems, Inc.





The
      following discussion of our financial condition and results of operations should
      be read in conjunction with our Financial Statements and Notes thereto, and
      the
      other financial information included elsewhere in this Form 10-QSB Report.
      This
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations contains descriptions of our expectations regarding future trends
      affecting our business. These forward-looking statements and other
      forward-looking statements made elsewhere in this document are made in reliance
      upon safe harbor provisions of the Private Securities Litigation Reform Act
      of
      1995. The following discussion sets forth certain factors we believe could
      cause
      actual results to differ materially from those contemplated by the
      forward-looking statements.





**Overview**





** Viking
      Systems, Inc. designs, manufactures, and markets FDA-cleared high performance
      laparoscopic vision systems. Viking’s primary product is the EndoSite 3Di
      Digital Vision System (the “EndoSite 3Di System”), an advanced three dimensional
      (“3-D”) vision system used by surgeons for complex minimally invasive
      laparoscopic surgery, with an initial focus on applications in urology,
      bariatrics, and laparoscopic gynecology. Viking Systems also manufactures
      advanced two dimensional (“2-D”) digital cameras that are sold through strategic
      partner and original equipment manufacture (“OEM”) programs.





In
      May
      2007, we launched our high Definition (HD) 3Di vision system in the United
      States. The HD system provides a more enhanced picture and the personal head
      display (“PHD”) is
      30% lighter than the existing head display and the ocular assembly is 40%
      smaller than the previous version offering the surgeon greater peripheral vision
      in the operating room.




Viking
      System’s technology and know-how center on its core technical competencies in
      optics, digital imaging, sensors, surgical robotics, and image management.
      Viking System’s focus is to deliver advanced integrated information,
      visualization, and control solutions to the surgical team, enhancing their
      capability and performance in complex, minimally invasive surgical
      procedures.





Viking
      System’s proprietary solutions for surgery are based on three principles:





**·**
            That
                3-D vision, providing natural depth perception and a clear view of
                a
                patient’s anatomy, is superior in facilitating the performance of complex
                surgical tasks;**·**
            That
                a PHD is a more ergonomic display solution for surgeons and interventional
                physicians than conventional video monitors; and**·**
            That
                integrating additional information in a voice controlled,
                picture-in-picture format into the surgeon’s view, in conjunction with the
                anatomical view, can facilitate decision making during
                surgery.





As
      of
      June 30, 2007, we had an installed base of more than sixty 3-D vision systems
      worldwide and more than 500 2-D digital cameras with OEM partners, including
      Boston Scientific Corporation and Medtronic, Inc. The list price for products
      typically range from $100,000 to $200,000 for EndoSite 3Di Systems and from
      $3,000 to $27,000 for 2-D digital cameras and components.





Effective
      July 25, 2006, we changed our domicile from the State of Nevada to the State
      of
      Delaware by way of a reincorporation merger. Our Certificate of Incorporation
      and Bylaws as a Delaware corporation are similar to the Articles of
      Incorporation and Bylaws we had as a Nevada corporation. In May 2007, we amended
      our Certificate of Incorporation in Delaware to increase the number of
      authorized common shares from 200,000,000 to 400,000,000 common
      shares.


16





**Use
      of Estimates and Critical Accounting Policies**





This
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations discuss Viking Systems’ Financial Statements, which have been
      prepared in accordance with accounting principles generally accepted in the
      United States.





The
      preparation of our financial statements requires management to make estimates
      and assumptions that affect reported amounts of assets and liabilities and
      the
      disclosure of contingent assets and liabilities at the date of the financial
      statements and the reported amounts of revenues and expenses during the
      reporting period. On an ongoing basis, management evaluates its estimates and
      assumptions, including those related to inventory, income taxes, long lived
      asset valuation, revenue recognition and stock based compensation. Management
      bases its estimates and judgments on historical experience of the operations
      and
      on various other factors that are believed to be reasonable under the
      circumstances, the results of which form the basis for making judgments about
      the carrying value of assets and liabilities that are not readily apparent
      from
      other sources. Actual results may differ from these estimates under different
      assumptions or conditions.





Management
      believes the following critical accounting policies, among others, will affect
      its more significant judgments and estimates used in the preparation of our
      Financial Statements.





***Inventory.*** Parts
      and
      supplies inventories are stated at the lower of cost or market. Cost is
      determined using the standard cost method. Work-in-process and finished goods
      are stated at the lower of the accumulated manufacturing costs or
      market. ****** Viking
      Systems reduces the stated value of its inventory for obsolescence or impairment
      in an amount equal to the difference between the cost of the inventory and
      the
      estimated market value, based upon assumptions about future demand and market
      conditions. If actual future demand or market conditions are less favorable
      than
      those projected by management, additional reductions in stated value may be
      required.





***Income
      Taxes.*** In
      determining the carrying value of Viking Systems’ net deferred tax assets,
      Viking Systems must assess the likelihood of sufficient future taxable income
      in
      certain tax jurisdictions, based on estimates and assumptions, to realize the
      benefit of these assets. If these estimates and assumptions change in the
      future, Viking Systems may record a reduction in the valuation allowance,
      resulting in an income tax benefit in Viking Systems’ Statements of Operations.
      Management evaluates the realizability of the deferred tax assets and assesses
      the valuation allowance quarterly.





Effective
      January 1, 2007, the Company adopted the provisions of Financial Accounting
      Standards Board ("FASB") Interpretation No. 48 ("FIN 48"), Accounting for
      Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109.
      The
      implementation of FIN 48 had no impact on the Company's financial statements.




The
      Company is primarily subject to U.S. federal and state income tax. Tax years
      subsequent to December 31, 2003 remain open to examination by U.S. federal
      and
      state tax authorities. In addition, the Company's policy is to recognize
      interest and penalties related to income tax matters in income tax expense.
      As
      of January 1 and June 30, 2007, the Company had no accruals for interest or
      penalties related to income tax matters.





***Amortization
      and Impairment of Long Lived Assets.*** Long
      lived assets, such as property, equipment and intangible assets are recorded
      at
      historical cost. We amortize our intangible assets using the straight-line
      method over their estimated useful lives, usually two to five years. We review
      intangible assets subject to amortization periodically to determine if any
      adverse conditions exist or a change in circumstances has occurred that would
      indicate impairment or a change in the remaining useful life. Conditions that
      would indicate impairment and trigger a more frequent impairment assessment
      include, but are not limited to a significant adverse change in the legal
      factors or business climate that could affect the value of an asset, or an
      adverse action or assessment by a regulator. If the carrying amount of an asset
      exceeds its estimated fair value, an impairment charge is recognized for the
      amount by which the carrying amount exceeds the estimated fair value of the
      asset. Assets to be disposed of are reported at the lower of the carrying amount
      or fair value, less the estimated costs to sell. In addition, depreciation
      of
      the asset ceases. During the years ended December 31, 2006 and 2005, no
      impairment of long-lived assets was recorded.




17





***Revenue
      Recognition*** .
      Our
      revenues are derived from the sale of surgical visualization technology products
      to end users, distributors and original equipment manufacturers. Revenue from
      the sale of products is recognized when evidence of an arrangement exists,
      the
      product has been shipped, the selling price is fixed or determinable, and
      collection is reasonably assured and when both title and risk of loss transfer
      to the customer, provided that no significant obligations remain. If
      installation is included as part of the contract, revenue is not recognized
      until installation has occurred, or until any remaining installation obligation
      is deemed to be perfunctory. Shipping and handling costs are included in cost
      of
      sales.





For
      the
      sale of products and services as part of a multiple-element arrangement, we
      allocate revenue from multiple-element arrangements to the elements based on
      the
      relative fair value of each element. The allocation of fair value for a
      multiple-element arrangement is based on vendor specific objective evidence
      (“VSOE”) or in absence of VSOE for delivered elements, the residual method. In
      the absence of VSOE for undelivered elements, revenue is deferred and
      subsequently recognized over the term of the arrangement. For sales of extended
      warranties with a separate contract price, Viking defers revenue equal to the
      separately stated price. Revenue associated with undelivered elements is
      deferred and recorded when delivery occurs.





***Stock-Based
      Compensation.*** On
      January 1, 2006 the Company adopted Statement of Financial Accounting Standards
      (“SFAS”) No.123 (Revised 2004), “ Share
      Based Payment ,”
(“SFAS
      123R”), using the modified prospective method. In accordance with SFAS 123R, the
      Company measures the cost of employee services received in exchange for an
      award
      of equity instruments based on the grant-date fair value of the award. That
      cost
      is recognized over the period during which an employee is required to provide
      service in exchange for the award - the requisite service period. The Company
      determines the grant-date fair value of employee share options using the
      Black-Scholes option-pricing model.





***Valuation
      of Derivative Liabilities.*** At
      each subsequent balance sheet date, the fair value of all warrants and other
      derivative liabilities are remeasured, and any changes in the fair value are
      recorded as a gain or loss on derivatives in the statement of
      operations.





**Recent
      Accounting Pronouncements**





In
      June
      2006, the FASB ratified the consensus on Emerging Issues Task Force ("EITF")
      Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental
      Authorities Should Be Presented in the Income Statement" ("EITF No. 06-3").
      The
      scope of EITF No. 06-3 includes any tax assessed by a governmental authority
      that is directly imposed on a revenue-producing transaction between a seller
      and
      a customer and may include, but is not limited to, sales, use, value added,
      Universal Service Fund ("USF") contributions and some excise taxes. The Task
      Force affirmed its conclusion that entities should present these taxes in the
      income statement on either a gross or a net basis, based on their accounting
      policy, which should be disclosed pursuant to APB Opinion No. 22, "Disclosure
      of
      Accounting Policies." If such taxes are significant and are presented on a
      gross
      basis, the amounts of those taxes should be disclosed. The consensus on EITF
      No.
      06-3 will be effective for interim and annual reporting periods beginning after
      December 15, 2006. The adoption of EITF 06-3 during the first quarter of 2007
      did not have a material impact on our financial position, results of operations
      or cash flows.





In
      November 2006, the EITF reached a final consensus in EITF Issue 06-06 “Debtor’s
      Accounting for a Modification (or Exchange) of Convertible Debt Instruments”
(“EITF No. 06-6”). EITF No. 06-6 addresses the modification of a convertible
      debt instrument that changes the fair value of an embedded conversion option
      and
      the subsequent recognition of interest expense for the associated debt
      instrument when the modification does not result in a debt extinguishment
      pursuant to EITF No. 96-19, “Debtor’s Accounting or a Modification or Exchange
      of Debt Instruments.” The consensus should be applied to modifications or
      exchanges of debt instruments occurring in interim or annual periods beginning
      after November 29, 2006. The adoption of EITF 06-6 during the first quarter
      of
      2007 did not have a material impact on our financial position, results of
      operations or cash flows.





In
      November 2006, the FASB ratified EITF Issue No. 06-7, “Issuer’s Accounting for a
      Previously Bifurcated Conversion Option in a Convertible Debt Instrument When
      the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement
      No. 133, Accounting for Derivative Instruments and Hedging Activities” (“EITF
      No. 06-7”). At the time of issuance, an embedded conversion option in a
      convertible debt instrument may be required to be bifurcated from the debt
      instrument and accounted for separately by the issuer as a derivative under
      SFAS
      No. 133, based on the application of EITF No. 00-19. Subsequent to the issuance
      of the convertible debt, facts may change and cause the embedded conversion
      option to no longer meet the conditions for separate accounting as a derivative
      instrument, such as when the bifurcated instrument meets the conditions of
      EITF
      No. 00-19 to be classified in stockholders’ equity. Under EITF No. 06-7, when an
      embedded conversion option previously accounted for as a derivative under SFAS
      No. 133 no longer meets the bifurcation criteria under that standard, an issuer
      shall disclose a description of the principal changes causing the embedded
      conversion option to no longer require bifurcation under SFAS No. 133 and the
      amount of the liability for the conversion option reclassified to stockholders’
equity. EITF No. 06-7 should be applied to all previously bifurcated conversion
      options in convertible debt instruments that no longer meet the bifurcation
      criteria in SFAS No. 133 in interim or annual periods beginning after December
      15, 2006, regardless of whether the debt instrument was entered into prior
      or
      subsequent to the effective date of EITF No. 06-7. Earlier application of EITF
      No. 06-7 is permitted in periods for which financial statements have not yet
      been issued. The adoption of EITF 06-7 during the first quarter of 2007 did
      not have a material impact on our financial position, results of operations
      or
      cash flows.





18


**RESULTS
      OF OPERATIONS**





**Three
      Month and Six Month Periods Ended June 30, 2007 Compared to the Three and Six
      Month Periods Ended June 30, 2006**





***Revenues.*** ** For
      the
      three months ended June 30, 2007, we had product sales of $2,849,544 compared
      to
      product sales of $883,180 for the three months ended June 30, 2006. This
      represents an increase of $1,966,364, or 223%. Sales to individual customers
      exceeding 10% or more of revenues in the three months ended June 30, 2007 were
      to three customers who accounted for 22.7%, 16.9%, and 10.9% of revenues,
      respectively. For the six months ended June 30, 2007, we had product sales
      of
      $4,774,789 compared to product sales of $2,138,024 for the six months ended
      June
      30, 2006. This represents an increase of $2,636,765, or 123%. Sales to
      individual customers exceeding 10% or more of revenues in the six months ended
      June 30, 2007 were to three customers who accounted for 21.5%, 17.2%, and 12.8%
      of revenues, respectively. The increase in sales for both the three and six
      month period ended June 30, 2007, as compared with the same periods in the
      prior
      year, was due to increased sales of the Company’s 3-D vision systems and
      increased volume of cameras sold to OEM customers.





***Gross
      Profit.*** We had
      gross profit of $814,788, or 29% of total revenues, for the three months ended
      June 30, 2007 and gross profit of $140,357, or 16% of total revenues, for the
      three months ended June 30, 2006, representing an increase of $674,431. We
      had
      gross profit of $1,359,818, or 29% of total revenues, for the six months ended
      June 30, 2007 and gross profit of $505,324, or 24% of total revenues, for the
      six months ended June 30, 2006, representing an increase of $854,494. The
      increase in gross profit during in the second quarter and first half of 2007
      was
      due to higher sales and a mix of higher margin product.





***Sales
      and Marketing Expenses*** **.** Selling
      and marketing expenses include costs for sales, marketing personnel, sales
      and
      marketing activities and tradeshow expenses. Selling
      and marketing expenses were $1,424,027 for the three months ended June 30,
      2007
      and $1,135,241 for the three months ended June 30, 2006. For the six months
      ended June 30, 2007, selling and marketing expenses were $2,568,800 compared
      to
      $2,009,609 for the six months ended June 30, 2006. The year-over-year increase
      in sales and marketing expenses was primarily due to increased salaries, travel,
      depreciation and tradeshow expense associated with our efforts to develop market
      awareness and to build our sales organization for our 3Di products. We expect
      that our selling and marketing expenses will continue to increase as we
      establish our 3Di Systems business with both domestic and international
      customers.





***Research
      and Development Expenses.*** ** Research
      and development expenses include costs associated with the design, development,
      testing and enhancement of our products *.* Research
      and development expenses were $626,512 for the three months ended June 30,
      2007
      and $314,036 for the three months ended June 30, 2006. For the six months ended
      June 30, 2007 research and development expenses were $1,038,429 compared to
      $624,260 for the six months ended June 30, 2006. The year-over-year increase
      is
      primarily due to hiring of additional engineering personnel to support new
      development projects, the development of the HD generation of the 3Di system,
      including the new Personal Head Display (“PHD”) which was launched in May 2007.
      We are working on the development of the next generation of *InfomatixTM* which
      will enable the system to not only display live imagery from video sources
      but
      will also include the ability to interface effectively with image guidance,
      various forms of patient monitoring equipment and allow the surgeon to view
      pre-staged surgical images intraoperatively. This effort will also include
      expanded digital video and image recording capability and interfaces to hospital
      administration systems moving to electronic medical records. During 2007 we
      also
      continued our research efforts on other complimentary products. We expect that
      our research and development expenses will increase as we continue to develop
      new products, and maintain and support our current products.





***General
      and Administrative Expenses.*** ** General
      and administrative expenses include costs for administrative personnel, legal
      and accounting expenses and general corporate matters. We had general and
      administrative expenses of $748,488 for the three months ended June 30, 2007
      and
      $684,434 for the three months ended June 30, 2006. For the six months ended
      June
      30, 2007, general and administrative expenses were $1,380,562 compared to
      $1,213,624 for the six months ended June 30, 2006. The increase for both periods
      is primarily due to increased personnel costs and legal expenses. We expect
      that
      our general and administrative expenses will increase from their current levels
      as we hire additional personnel, implement and document internal controls in
      connection with our efforts to become compliant with requirements of Section
      404
      of The Sarbanes - Oxley Act of 2002 and expend resources on the implementation
      of a new ERP system.





19





***Other
      Income and Expenses.*** We
      had
      interest income of $14,045 and $21,787 for the three months ended June 30,
      2007
      and 2006, respectively, and $29,454 and $21,787 for the six months ended June
      30, 2007 and 2006, respectively. Interest income for 2006 was higher as a result
      of the proceeds of the preferred stock financing in 2006 being deposited in
      interest bearing accounts.





Interest
      expense amounted to $230,628 for the three months ended June 30, 2007 compared
      to $160,584 for the three months ended June 30, 2006. Interest expense amounted
      to $412,915 for the six months ended June 30, 2007 compared to $305,995 for
      the
      six months ended June 30, 2006. Interest for the six months ended June 30,
      2007
      related primarily to the interest on the Debentures whereas the interest for
      the
      corresponding period in 2006 related to the convertible notes that were
      converted to preferred stock in 2006.





We
      had a
      $4,975,824 gain on the extinguishment of debt for both the three months and
      the
      six months ended June 30, 2006. We had no such income in the comparable periods
      in 2007. The gain on extinguishment of debt resulted from the difference between
      the deemed reacquisition value of the convertible notes on the date conversion
      terms were modified in 2006 ($5,250,000) less the fair value of the modification
      of the warrants issued under the new conversion terms ($274,176).





We
      had
      non-cash amortization of debt discount expenses of $462,056 for the three months
      ended June 30, 2007 and amortization of debt discount expenses of $5,500,000
      for
      the three months ended June 30, 2006, representing a decrease of $5,037,944.
      Amortization of debt discount expenses for the six months ended June 30, 2007
      totaled $605,486 and for the six months ended June 30, 2006 were $8,480,878,
      representing a decrease of $7,875,392. The 2006 amount includes $5,250,000
      in
      non-cash expense representing the deemed reacquisition value of convertible
      notes when their conversion terms were modified. We also recognized the fair
      value of all the Company’s warrants with the recognition of a non-cash
      derivative liability income of $1,816,842 of the three months ended June 30,
      2007 and expense of $1,612,610 for the three months ended June 30, 2006. For
      the
      six months ending June 30, 2007 and 2006, we recognized a loss on derivative
      liability in the amounts of $615,897 and $1,612,610, respectively.





We
      also
      had accrued liquidated damages in the amount $577,616 for the three and six
      months ended June 30, 2007. There were no such amounts for 2006. Those amounts
      related to the expense related to the failure to register the common shares
      underlying the Series B Preferred Stock and the Debentures. We anticipate that
      we will continue to have liquidated damages in the future based upon the
      provisions of the Preferred Stock and Debenture documents.





***Net
      Income (Loss).*** We had a
      net loss of $1,423,652 for the three months ended June 30, 2007 and a net loss
      of $4,268,937 for the three months ended June 30, 2006. The reduction in net
      loss for the second quarter in 2007 from 2006 is primarily due to the change
      in
      the derivative liability fair value resulting in income of $1,816,842 in 2007
      versus a loss of $1,612,610 in 2006. We had a net loss of $5,810,433 for the
      six
      months ended June 30, 2007 and a net loss of $8,744,041 for the six months
      ended
      June 30, 2006, representing a decrease in our net loss by $2,933,608 for the
      first half of 2007 compared to the first half of 2006. The 2007 increase of
      gross profit of $854,494 was offset by the increase of operating expenses in
      the
      amount of $1,140,298 as we incurred significant costs implementing our sales
      and
      marketing plan, developing and improving our 3Di product line, and maintaining
      operations of the Visualization business. During 2006 we also incurred
      $8,480,878 in non-cash interest expense related to the amortization of the
      debt
      discount on the Convertible Notes and $1,612,610 in non-cash derivative loss,
      partially offset by a $4,975,824 gain on the extinguishment of debt. In the
      six
      month period ended June 30, 2007, we had $605,486 in amortization of debt
      discount and $1,816,842 in derivative liability gain.





**LIQUIDITY
      AND CAPITAL RESOURCES**





We
      have
      financed our operations principally through private sales of equity securities
      and convertible notes. From January 1, 2004 through June 30, 2007, we have
      raised net proceeds of $8,150,000 through the sale of common and preferred
      stock
      in private placements and approximately $11,000,000 through the issuance of
      convertible promissory notes. Additionally, in July 2007 we raised $2,600,000
      through the sale of convertible debentures. As of June 30, 2007, we had cash
      and
      cash equivalents of $314,580 compared to $440,465 as of December 31, 2006.
      We
      incurred operating losses in 2007 and 2006, and at June 30, 2007, had an
      accumulated deficit of approximately $24,358,745.




20





We
      anticipate that we will have adequate cash resources to fund our operations
      approximately through September 2007. We will need to raise additional funds
      through the issuance of debt or the sale of additional equity securities to
      maintain sufficient operating capital. Thereafter, our liquidity and capital
      requirements will depend upon numerous other factors, including the
      following:




**·**
            The
                extent to which our products and services gain market
                acceptance;**·**
            The
                progress and scope of product evaluations;**·**
            The
                timing and costs of filing future regulatory
                submissions;**·**
            The
                timing and costs required to receive both domestic and international
                governmental approvals;**·**
            The
                timing and costs of acquisitions and product and services
                introductions;**·**
            The
                extent of our ongoing research and development
                programs;**·**
            The
                costs of sponsorship training of physicians to become proficient
                in the
                use of our products and procedures; and**·**
            The
                costs of developing marketing and distribution
                capabilities.





If
      we are
      unable to raise such funds we may be required to reduce operations, reduce
      or
      discontinue further research and development, and/or reduce or eliminate further
      acquisition activities. Additionally, increases in expenses or delays in product
      development or failure to achieve our sales projections may adversely impact
      our
      cash position and may require cost reductions or require the Company to seek
      additional financing. There can be no assurance that such financing will be
      available on acceptable terms, or at all. We do not have any arrangements with
      any bank or financial institution to secure additional financing and there
      can
      be no assurance that any such arrangement, if required or otherwise sought,
      would be available on terms deemed to be commercially acceptable and in our
      best
      interests.





The
      transaction documents relating to both the Preferred Stock transaction and
      the
      Convertible Debenture transaction are complex, subject us to numerous
      requirements and provide the investors with numerous rights, including, but
      not
      limited to, liquidated damages rights, default rights, rights to accelerate
      required payments and required repurchase rights. We have been in default in
      certain provisions of the transaction Documents for both transactions. Some
      of
      these defaults were related to our obligations to register underlying securities
      and pay preferred stock dividends. If the investors in the Preferred Stock
      transaction and the Convertible Debenture transaction were to declare a default
      and demand repayment or exercise other rights, there can be no assurance that
      we
      would be able to continue with our business operations. In such event, our
      shareholders would likely suffer a complete loss of their investment. If our
      preferred stockholders or debenture holders were to demand repayment due to
      a
      breach of our obligations, it is unlikely we would be able to do so. This could
      result in a severe adverse consequence to Viking and its shareholders. All
      of
      the assets of Viking have been pledged to secure our obligations to the
      convertible debenture holders. If they were to foreclose on these assets, we
      would not be able to continue with our operations.





Net
      cash
      used in operating activities was $4,950,842 **** and
      $3,252,383 during the six months ended June 30, 2007 and June 30, 2006,
      respectively. The increase in net cash used in operating activities during
      2007
      compared to 2006 was attributable primarily to increases in inventories and
      accounts receivable supporting the growth in the Company’s business
      activities.





Net
      cash
      used in investing activities was $83,095 and $112,421 during the six months
      ended June 30, 2007 and June 30, 2006, respectively. The higher level of cash
      used in investing activities in 2006 was attributable to purchases of
      demonstration equipment of our 3Di product line in support of our sales and
      marketing efforts. Subject to cash availability, we anticipate increasing our
      level of capital expenditures in the second half of 2007 to provide our sales
      and marketing personnel and distribution partners with new generation 3Di
      demonstration systems.





Cash
      flow
      provided by financing activities was $4,908,052 and $6,852,658 during the six
      months ended June 30, 2007 and June 30, 2006, respectively. The cash flows
      from
      financing activities in the six months ended June 30, 2007 consisted of
      $4,927,848 in net proceeds from related party notes payable and Debentures,
      offset by $19,796 in repayments of capital lease obligations. Cash provided
      by
      financing activities in 2007 also consisted of $200,000 as a deposit on the
      financing. The cash flows from financing activities in 2006 consisted of
      $6,813,858 in net proceeds from our preferred stock financing and $250,000
      from
      notes payable, partially offset by a $211,200 reduction in short-term bank
      borrowings.





21





During
      2005, Viking Systems issued Convertible Promissory Notes (“Notes”) to certain
      accredited investors. Each of these investors was also issued a warrant to
      purchase shares of Viking Systems common stock. In May 2006, each of the Note
      holders converted their Notes into shares of Viking Systems common stock. In
      April 2006, Viking Systems agreed to file, prior to June 21, 2006, a
      registration statement covering the shares of common stock issued upon the
      conversion of the Notes and shares of common stock underlying the warrants
      of
      these former Note holders. As a result of the required terms of the Series
      B
      Preferred Stock transaction in 2006, we were unable to include the securities
      of
      the former Note holders in the first registration statement. During August
      2006,
      we agreed to pay a delay fee to the note purchasers at the rate of one percent
      per month to those former Note holders who elect to receive a fee. The delay
      fee
      began on June 21, 2006 and terminates on the date the Securities and Exchange
      Commission declares effective a registration statement covering the securities
      of the Note purchasers. Given the former Note holders who have waived the fee
      to
      date, we expect the aggregate monthly delay fee to be approximately $21,000.
      We
      are unable to predict when the delay fee will terminate. Through June 30, 2007,
      the cumulative accrued delay fee totaled $258,300.





***Off-Balance
      Sheet Arrangements.*** We do
      not have any off balance sheet arrangements that are reasonably likely to have
      a
      current or future effect on our financial condition, changes in our financial
      condition revenues or expenses, results of operation, liquidity, capital
      expenditures or capital resources that is material to our investors.





**Forward
      Outlook and Risks**





This
      Form
      10-QSB contains certain “forward-looking statements” within the meaning of
      Section 27A of the Securities Act and Section 21E of the Exchange Act with
      respect to results of our operations and businesses. All statements, other
      than
      statements of historical facts, included in this Form 10-QSB, including those
      regarding market trends, our financial position, business strategy, projected
      costs, and plans and objectives of management for future operations, are
      forward-looking statements. In general, such statements are identified by the
      use of forward- looking words or phrases including, but not limited to,
“intended,” “will,” “should,” “may,” “expects,” “expected,” “anticipates,” and
“anticipated” or the negative thereof or variations thereon or similar
      terminology. These forward-looking statements are based on our current
      expectations. Although we believe that the expectations reflected in such
      forward-looking statements are reasonable, there can be no assurance that such
      expectations will prove to be correct. Because forward-looking statements
      involve risks and uncertainties, our actual results could differ materially.
      Important factors that could cause actual results to differ materially from
      our
      expectations are disclosed hereunder and elsewhere in this Form 10-QSB. These
      forward-looking statements represent our judgment as of the date of this Form
      10-QSB. All subsequent written and oral forward-looking statements attributable
      to us are expressly qualified in their entirety by the cautionary statements
      referred to in this section. We disclaim, however, any intent or obligation
      to
      update our forward-looking statements.





Except
      as
      set forth below, during the quarter ended June 30, 2007, there were no material
      changes to the quantitative and qualitative disclosures of our Risk Factors
      previously reported in the Annual Report contained in the Company's Form 10-KSB
      for the year ended December 31, 2006. See "Risk Factors" in the Company's in
      the
      Managements Discussion an Analysis Section of  Form 10-KSB for the year
      ended December 31, 2006 for a detailed discussion.





***Issuance
      of Convertible Debentures.*** In
      February 2007, Viking Systems **** issued
      a
      total of $5,376,533 of 8% convertible debentures to 13 investors. These
      Debentures mature two years from the date of issuance or may be accelerated
      upon
      default by Viking Systems. Viking Systems may issue additional Debentures.
      We
      are required to pay interest on these Debentures at 8% per annum. The Debentures
      are secured by all of the assets of Viking Systems. The Debentures may, at
      the
      option of the Investors, be converted into shares of Viking Systems common
      stock
      at the price of $0.18 per share. In the event Viking Systems does not achieve
      certain operation milestones (described in the Debentures Warrants transaction
      documents) during the first three quarters of 2007, the conversion price will
      be
      reduced to $0.12 per share. The conversion price is also subject to downward
      adjustment, upon certain conditions pursuant to the terms of Security Purchase
      Agreement, the Debentures and other Transaction Documents. The other terms
      and
      conditions of the Debentures are described in Note 10 to the financial
      statements included in this form 10-QSB.





As
      additional consideration for the Investors purchasing the Debentures, Viking
      Systems has issued to the Investors Warrants to purchase shares of Viking
      Systems common stock at the price of $0.18 per share. In the event Viking
      Systems does not achieve certain operation milestones (described in the Warrants
      and the Debentures transaction documents) during the first three quarters of
      2007, the exercise price will be reduced to $0.12 per share. The exercise price
      is also subject to downward adjustment, upon certain conditions pursuant to
      the
      terms of Security Purchase Agreement, the Warrant and other Transaction
      Documents. The Warrants are exercisable for a period of seven years from the
      date of issuance. The Warrants provide that each Investor is issued to purchase
      that number of shares of common stock of Viking Systems that equals 50% of
      the
      number of shares issuable upon conversion of the Debentures.




Viking
      Systems has agreed to register with the Securities and Exchange Commission,
      the
      shares of common stock that are issuable upon the conversion of the Debentures
      and the shares of common stock that underlie the Warrants. Viking Systems will
      pay all expenses and cost of registration except for commissions. In the event
      the securities underlying the debentures and warrants are not registered by
      the
      dates agreed to in the transaction documents, Viking Systems will be required
      to
      pay liquidated damages to the Holders. Such liquidated damages amount to 2%
      per
      month but will not exceed 18% of the face amount of the Debentures. Viking
      Systems has not filed a registration statement relating to the Debenture
      Transaction Shares, which constitutes a default by Viking Systemsof the terms
      and conditions of the Debenture transaction documents.





On
      July
      19, 2007, Viking Systems and the Debenture holders entered into a Consent,
      Waiver and Amendment Agreement dated June 22, 2007, pursuant to which Viking
      agreed to issue to the Investors a total of 2,389,570 shares of Viking common
      stock in lieu of the payment of (i) accrued but unpaid cash liquidated damages
      and (ii) the payment of accrued interest on the debentures through June 30,
      2007. These shares were issued by Viking in July 2007.





22





***Additional
      Financing Requirements.*** We issued $5,376,533 in convertible a Debentures transaction in February
      2007 and another $2,600,000 in July 2007. We anticipate that we will have
      adequate cash resources to fund our operations approximately through September
      2007. We are attempting to raise additional funds through debt or the sale
      of
      additional equity securities to maintain sufficient operating capital.
      Thereafter, our liquidity and capital requirements will depend upon numerous
      other factors, including the following:




**·**
            The
                extent to which our products and services gain market
                acceptance;**·**
            The
                progress and scope of product evaluations;**·**
            The
                timing and costs of filing future regulatory
                submissions;**·**
            The
                timing and costs required to receive both domestic and international
                governmental approvals;**·**
            The
                timing and costs of acquisitions and product and services
                introductions;**·**
            The
                extent of our ongoing research and development
                programs;**·**
            The
                costs of sponsorship training of physicians to become proficient
                in the
                use of our products and procedures; and**·**
            The
                costs of developing marketing and distribution
                capabilities.





We
      are
      seeking additional financing in order to fund our operations and carry out
      our
      business plan. There can be no assurance that such financing will be available
      on acceptable terms, or at all, and there can be no assurance that any such
      arrangement, if required or otherwise sought, would be available on terms deemed
      to be commercially acceptable and in our best interests.




***Obligations
      to Pay Dividends on Our Preferred Stock.*** The Company is in default
      with respect to its obligation to pay dividends on the Series B Preferred Stock.
      We have accumulated unpaid preferred stock dividends at June 30, 2007 in the
      amount of $710,000. The Company has not had sufficient capital to pay such
      dividends in cash. Although the Company does not have a contractual right to
      pay
      the dividends in common stock, we intend to discuss with our preferred
      shareholders paying the accrued dividends and future dividends in stock. There
      can be no assurance that the preferred stockholders will allow dividends to
      be
      paid with shares rather than cash and if this were to occur, Viking may not
      have
      the cash necessary to pay such dividends. We continue to accrue approximately
      $161,000 in preferred dividends on a quarterly basis.




***Obligation
      to Pay Interest on Our Convertible Debentures.***We have accumulated
      and unpaid interest on our Convertible Debentures issued on June 30, 2007 in
      the
      amount of $107,531. In July 2007, the Convertible Debenture holders agreed
      to
      receive the quarterly interest payment of $107,531 in the form of Company’s
      common stock at $0.18 per share totaling 597,394 shares. We may not have the
      ability to pay this interest in cash in future periods.




***Potential
      Impact from Defaults.*** The Transaction Documents relating to both
      the Preferred Stock Transaction and the Convertible Debenture Transaction are
      complex, subject us to numerous requirements and provide the investors with
      numerous rights, including, but not limited to, liquidated damages rights,
      default rights, rights to accelerate required payments and required repurchase
      rights. We have been in default in certain provisions of the Transaction
      Documents for both transactions. Some of these defaults were related to our
      obligations to register underlying securities. We have received some waiver
      of
      some of the defaults in the past, but there can be no assurance that we have
      received waivers for all of such defaults or that we will receive waivers for
      any future defaults. If the investors in the Preferred Stock transaction and
      the
      Convertible Debenture transaction were to declare a default and demand repayment
      or exercise other rights, there can be no assurance that we would be able to
      continue with our business operations. In such event, our shareholders would
      likely suffer a complete loss of their investment.




***Failure
      to Achieve and Maintain Effective Internal Controls.***Pursuant to
      current rules related to Section 404 of the Sarbanes-Oxley Act of 2002 (“Section
      404”), beginning with our Annual Report on Form 10-KSB for the fiscal year
      ending December 31, 2007, we will be required to furnish a report by our
      management on our internal control over financial reporting.




23





In
      order
      to achieve compliance with Section 404 within the prescribed period, we will
      need to engage in a process to document and evaluate our internal control over
      financial reporting, which will be both costly and challenging. In this regard,
      management will need to dedicate internal resources, engage outside consultants
      and adopt a detailed work plan.





During
      the course of our testing, we may identify deficiencies that we may not be
      able
      to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act
      for
      compliance with the requirements of Section 404. In addition, if we fail to
      achieve and maintain the adequacy of our internal controls, as such standards
      are modified, supplemented or amended from time to time, we may not be able
      to
      ensure that we can conclude on an ongoing basis that we have effective internal
      controls over financial reporting in accordance with Section 404 of the
      Sarbanes-Oxley Act. Moreover, effective internal controls, particularly those
      related to revenue recognition, are necessary for us to produce reliable
      financial reports and are important to helping prevent financial fraud. If
      we
      are unable to comply with Section 404 requirements on a timely basis, or if
      we
      cannot provide reliable financial reports or prevent fraud, then our business
      and operating results could be harmed, investors could lose confidence in our
      reported financial information, and the trading price of our stock could drop
      significantly.





There
      were no changes in our internal controls over financial reporting identified
      in
      connection with the evaluation required by paragraph (d) of Exchange Act Rules
      13a-15 or 15d that occurred during the last quarter that have materially
      affected, or are reasonably likely to materially affect our internal control
      over financial reporting.





**ITEM
      3. CONTROLS AND PROCEDURES**





**EVALUATION
      OF DISCLOSURE CONTROLS AND PROCEDURES**




We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed in our reports under the Securities
      Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed,
      summarized and reported within the time periods specified in the Securities
      and
      Exchange Commission’s rules and forms, and that such information is accumulated
      and communicated to our management, including our Chief Executive Officer and
      Chief Financial Officer, as appropriate, to allow timely decisions regarding
      required disclosure.





As
      of the
      end of the period covered by this report, we conducted evaluation, under the
      supervision and with the participation of our Chief Executive Officer and Chief
      Financial Officer, of the effectiveness of the design and operation our
      disclosure controls and procedures pursuant to Rule 13a-15e or 15d-15e of the
      Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief
      Financial Officer concluded that, as of the end of the period covered by this
      report, our disclosure controls and procedures were not effective at the
      reasonable assurance level. They have concluded that there are deficiencies
      in
      our controls.  We are reviewing our disclosure controls and procedures and
      our internal controls over financial reporting and implementing changes to
      our controls and procedures to improve its effectiveness. These
      changes are expected to include hiring of additional finance and accounting
      personnel, enhancements to improve our internal review process,  improved
      communication among those responsible for financial accounting and
      disclosure and more formalized processes and procedures.  Lack of
      sufficient capital will adversely impact our ability to improve our controls
      and
      procedures.





We
      continually seek to improve and strengthen our control processes to ensure
      that
      all of our controls and procedures are adequate and effective. We believe that
      a
      control system, no matter how well designed and operated, can only provide
      reasonable, not absolute, assurance that the objectives of the controls system
      are met. In reaching a reasonable level of assurance, management necessarily
      was
      required to apply its judgment in evaluating the cost-benefit relationship
      of
      possible controls and procedures. In addition, the design of any system of
      controls also is based in part upon certain assumptions about the likelihood
      of
      future events, and there can be no assurance that any design will succeed in
      achieving its stated goals under all potential future conditions. Over time,
      a
      control may become inadequate because of changes in conditions, or the degree
      of
      compliance with policies or procedures may deteriorate. No evaluation of
      controls can provide absolute assurance that all control issues and instances
      of
      fraud, if any, within a company will be detected.




**Changes
      in Internal
      Controls**


Near
      the end of the second quarter, the Company hired a
      new Chief Financial Officer who has significant experience with public reporting
      companies. Changes to the Company's internal controls over financial reporting
      and the disclosure controls will be assessed as part of the ongoing
      evaluation.





**PART
      II - OTHER INFORMATION**





Item
      1  Legal
      Proceedings .
      From
      time to time, the Company may become involved in various lawsuits and legal
      proceedings which arise in the ordinary course of business. The Company is
      currently not aware of nor has any knowledge of any such legal proceedings
      or
      claims that we believe will have, individually or in the aggregate, a material
      adverse affect on our business, financial condition or operating results.





Item
      2  Unregistered
      Sales of Equity Securities and Use of Proceeds .
      During
      the quarter ended June 30, 2007, we issued an aggregate of 990,977 shares of
      our
      common stock in an unregistered transaction. Such shares were issued in
      connection with the conversion of convertible Series B preferred stock and
      certain accrued dividends into shares of our common stock at the price of $.18
      per share. Such shares of common stock and Series B Preferred Stock were not
      registered and were issued in reliance on Section 4(2) of the Securities Act
      of
      1933, as amended.








24





Item
      3.  Defaults
      Upon Senior Securities .
      We are
      required to pay dividends under the terms of our Series B Preferred Stock
      transaction documents. We have failed to pay dividends to date, and are accruing
      interest on the unpaid dividends at 18% per annum per the terms of our
      agreement. As of June 30, 2007, the amount of unpaid dividends totals
      approximately $710,000.





The
      Company is in default of certain registration rights obligations to its Seris
      B
      Preferred shareholders. A registration statement for some, but not all, of
      the
      shares of common stock underlying the Series B Preferred Stock was declared
      effective by the Securities and Exchange Commission (“SEC”) on August 10, 2006.
      As of May 11, 2007, such registration statement was no longer current. As a
      result, on or about July 11, 2007, a “Triggering Event” occurred under the
      Series B Transaction Documents (which provides the Series B Preferred
      Shareholders rights to additional dividends and/or redemption in exchange for
      common stock). In addition, pursuant to the Registration Rights Agreement
      entered into in connection with the issuance of the Series B Preferred Stock,
      as
      a result of the lapse in the registration statement, the preferred shareholders
      are entitled to and the Company is currently incurring liquidated damages in
      connection with the previously-registered shares. The Company has accrued
      $257,741 at June 30, 2007 for such liquidated damages. The Company has prepared
      and filed an updated registration statement with current financial statements
      by
      way of a post-effective amendment but such post-effective amendment was not
      yet
      declared effective at the time of this Quarterly Report on Form 10-QSB. While
      we
      have not received a notice of default regarding the triggering Event, receipt
      of
      such notice would trigger a cross default under the terms of the
      Debenture.





Item
      4.  Submission
      of Matters to Vote of Security Holders .
      N/A





Item
      5.  Other
      Information .
      None





Item
      6. Exhibits




ExhibitNumber
            Exhibit31.1
            Certification
                of Chief Executive Officer in accordance with 18 U.S.C. Section 1350,
                as
                adopted by Section 302 of the Sarbanes- Oxley Act of 200231.2
            Certification
                of Principal Financial Officer in accordance with 18 U.S.C. Section
                1350,
                as adopted by Section 302 of the Sarbanes-Oxley Act of 200232.1
            Certification
                of Chief Executive Officer in accordance with 18 U.S.C. Section 1350,
                as
                adopted by Section 906 of the Sarbanes-Oxley Act of 200232.2
            Certification
                of Chief Financial Officer in accordance with 18 U.S.C. Section 1350,
                as
                adopted by Section 906 of the Sarbanes-Oxley Act of
                2002


_________________





25





SIGNATURE





In
      accordance with the requirements of the Exchange Act, the Company has caused
      this report to be signed on its behalf by the undersigned thereunto duly
      authorized.





Dated:
                August 20, 2007
            VIKING
                SYSTEMS, INC.By/s/
                Donald
                TuckerChief Executive Officer, PresidentBy/s/Robert MathewsChief Financial Officer










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